The Thrift Savings Plan’s F Fund is second only to the G Fund when it comes to low volatility among the
TSP’s five funds.

Like the G Fund, the F Fund’s returns are based on fixed-income investments; — bonds and notes. There
are distinct differences between the two, however.

Understanding these differences, and how they affect the risk and return characteristics of the fund, can
help you build a portfolio that is well-suited for your needs.

The G Fund offers a variable rate of return based on Treasury securities with an average maturity of
about 15 years. In addition, it offers a nearly stable share price, so that it is completely liquid.

So the G Fund has risk characteristics similar to those of a money market fund, but with better returns,
similar to those of intermediate or long-term bonds.

In contrast, the F Fund’s risk and return characteristics are based on a large and diverse collection of
bonds — an index called the Lehman Brothers U.S. Aggregate Bond Index. You can learn more about this
index at Investing in a well-diversified portfolio of bonds significantly reduces some of
the risk associated with owning a single, or a few, individual bonds without significantly reducing the
expected returns over the long run.

The F Fund tracks this index, and except for some minor variance, behaves identically to it. For the sake
of simplicity, in this discussion, I’ll treat the fund as though it were the index.

Because the F Fund is a bond-based security, it, like bonds, derives income from interest payments
received by the bond issuers. The value of a bond may rise and fall continuously as the supply and
demand change, usually in response to changes in interest rates.

In general, as market interest rates rise, bond prices fall. This is because a bond’s interest payment is
usually a fixed dollar amount. When a bond is issued, this dollar amount is set to provide a market interest
rate. If market interest rates subsequently rise, investors will pay less money for the bond because its
interest payment is low compared with the market rate; the bond sells at a discount. If market interest
rates fall, investors will pay more money for the bond; the bond sells at what is called a premium.

Because the changes in a bond’s price are linked to interest rates, the price change tends to be more
restrained than price fluctuations for equity securities. This is because market interest rates tend to move
in a range between, say, zero and 20 percent. And a bond’s price will rise or fall by the amount necessary
to make the bond’s interest payment correspond to the market’s rate of return for similar investments.

The price of long-term bonds is more sensitive to changes in interest rates than short-term bonds, and
their prices are generally more volatile.

One indicator of a bond’s or bond fund’s volatility is a statistic called duration, which indicates its
sensitivity to a change in interest rates. At last check, the TSP reported that the average duration of the F
Fund’s index holdings was 4.4 years. This means that the fund’s price can be expected to change by
about 4.4 percent for each 1 percent change in market interest rates. Investors should keep this in mind
when setting their expectations for the fund’s future performance.

Market timers frequently advise investors to avoid bond investments when interest rates are expected to
rise. Unfortunately, predicting the direction, timing and duration of interest rate movements is as difficult
as it is for stock prices, and long-term investors would be better advised to focus on the advantages that
bonds may offer as part of an appropriate asset allocation strategy.

Bonds often move in ways that are either independent of, or poorly correlated to, stocks. This means that
some of the volatility of each component will be canceled out by opposing price changes in the other

For example, if you are building a portfolio designed to produce an average rate of return of 7 percent,
using a combination of bond and stock components, each with an expected average rate of return of 7
percent, will yield a less volatile portfolio than either of the components alone.

The average annual rate of return for the F Fund has been 7.9 percent since its inception in January
1988. This is not bad when you consider that the fund produced a loss in only two out of the 16 years in
this period. Furthermore, the worst loss in any calendar year was 2.96 percent in 1994, and this was
followed in 1995 by the fund’s best year so far, returning 18.31 percent.

Compare these figures with the TSP’s stock funds — the C, S or I funds — and you’ll appreciate the more
restrained price fluctuations of bond investments.

The F Fund is extremely well-diversified, with more than 4,000 holdings in U.S. government, foreign
government, mortgage-backed and corporate bonds. The fund contains only investment-grade bonds, no
junk bonds, spread over a wide range of maturities. In short, the F Fund is representative of the U.S.
bond market as a whole.

And the F Fund’s management expenses , the cost investors pay to administer the fund, are quite low at
0.10 percent of assets. This is important for a bond investment since rates of return tend to hover
between 4 percent and 9 percent over the long term, and losing 1 percent to expenses can mean a 10
percent to 25 percent reduction in return.

Most portfolios I’ve worked with over the years have benefited from a bond allocation of between 10
percent and 60 percent, depending upon the investor’s time horizon and required rate of return. Even a
growth portfolio should have a small allocation to bonds — say, 10 percent. This tends to dampen a
portfolio’s volatility while contributing significantly to overall returns.

The F Fund provides an efficient, low-cost way to add bonds to your investment portfolio.

Written by Mike Miles
For the Federal Times
Publication October 4, 2004